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Value proposed and confirmed

The notion of subjective value, when we look at it in detail, suggest to us a new idea about how value works in the marketplace.

If value is in the eye of the beholder – in other words if it is subjective and dependent on the needs and desires of the consumer – than it is not fully and permanently added when the product is created or the service is rendered. A product (and in most cases we can by extension take this to include services) may be made by an artisan or a worker at a factory, but the value of that product still depends on it being consumed.

This suggests that value does not exist in the product as intrinsic theories of value suggest. That further suggests an interesting idea about where the value is stored once it is in the economy (that which is not stored in the form of money) but we’ll treat that as a separate issue for the moment.

We can say that the price a product sells for is socially determined, in other words the acts of buying and selling require human interaction. And we can see that it is at this point of interaction that the parties first declare at least one fixed version of the product’s value.

So - in the act of buying the consumer announces an opinion of the product. The price may in fact be higher or lower than the one envisioned by the producer, so the product’s evaluation may vary greatly from what the product’s maker though it would be. But in that moment, the snapshot, the price agreed on by the buyer and seller is what’s recorded.

So further, we can say the value of the product is proposed or nominated until it has been confirmed by passing into the broader economy, society’s collective subjective machine for evaluating value. By going though the marketplace, a product joins what we can describe as a more permanent version of the economy and is absorbed into the web of the broader social context where more permanent value rests.

But that sounds a lot grander than it should. Let’s not exaggerate the normal distance we could suggest exists between proposed value and confirmed value. In most cases (when the product is well known) the transition can be nearly instantaneous. In fact there are lots of ways the distance can be compressed – for example products can be contracted for before being made, or services might be paid for before they are performed. Contracts and business agreements mean the legal system could be said to bridge the distance, often taking much of the risk out of the process for producers.

And there are always going to be weird cases – it probably says something about theory of value that we could still probably find Pet Rocks being sold on e-Bay, but who knows what that means – still the bulk of value seems to be determined by the consumer.

In some ways this theory of proposed and confirmed value works better in aggregate, at the level of macro-economics rather than the individual, micro-economic level. For example, what is a speculative bubble if not a growing backlog of proposed value that might not be confirmed?

Let’s take a longer look at that. In the aggregate we can see that proposed value becoming confirmed value matches the process of monetary expansion regulated by interest rates– businesses and consumers going into debt in the expectation of enough economic growth to pay the debt off. By going into debt they are proposing value, which is then confirmed or denied in the context of a web of social and economic relationships. It could be said that if the aggregate of these individuals succeed and their proposed value is confirmed, that is when the economy grows, as does the monetary system that reflects the economy.

But value can be created (or at least nominated and proposed) in a more wholesale way by the financial markets. These markets produce debt much more quickly than consumers and small businesses. So for example, an institution in one of those markets will create or underwrite financial instruments worth millions of dollars at a time. It looks obvious that this could become a problematic form of value proposal.

So according to our theory, much of this debt is perfectly conventional and works in a reliable way. But not always. The institution could produce more experimental kinds of financial instruments. Or perhaps some kind of bonds (or stocks, or whatever) that might have had an initial reason for being have been pushed until they have drifted away from their original intention.

Take commodities derivatives. If a farmer is dependent on the price of wheat, he or she might decide to sell the crop short (selling a contract for a bushel of wheat he or she does not own, with the hope of being able to buy it back later at a lower price) as a way of offsetting losses if the crop price drops. The farmer thereby hedges his or her bet; hence the names hedge funds.

However, what has happened in recent years is that the market for derivatives has grown until it outstrips any substantial economic use. For example, in 2006 there were nearly $500 trillion in outstanding derivatives – ten times the net worth of all the world’s stock markets combined. At that point it seems the derivatives are no longer hedging, they’re gambling.

Jon Taplin has taken to describing these kinds investments as synthetic instruments, pieces of paper that in theory are worth something (and in theory have value) but have no real collateral at all. It’s an apt description.

But how do we know where that line is? Regulators are familiar with the problem, they simply lack a good way to separate the genuine hedges from the poker chips.

So let’s back up. Say at a corner of the market, investment houses are introducing a new kind of derivative. By it’s nature the derivative is somewhat removed from the broader economy (a derivative, after all, only derives its price from its relationship to some underlying instrument or commodity) where all value ultimately has to prove itself. Since the derivative has (in all probability) been leveraged into existence (issued on credit) we could say the derivative is largely proposed value, and even what is solid in it may be the money of investors who are at arms length from the derivative’s creation.

Similarly the market where this new kind of derivative is first sold is probably highly specialized, and largely hidden from the public. And from the general economy. So the new derivative starts to look a bit like the juggler’s ball, suspended in mid-air, shielded from the collective subjective decision making process.

Eventually of course all this proposed value has to fall to earth, but there are strong incentives to keep it in the air as long as possible – the new derivative is not worth very much if it falls to the ground and doesn’t bounce. There are of course lots of structures designed to force the testing of the new derivative’s value – prospectus reports, rating agencies, government regulation, public scrutiny. But we can see that if the juggler is good enough these can be avoided. And the derivative remains on the books at its proposed value, untested.

According to our theory this is not a bad problem if the derivative is small, or if it’s the only ball in the air. But this suspension of testing can be a problem if the derivative is part of a bubble. And we might say that going to market by itself is not a total guarantee of the value being properly examined. Consider the bubbles that can even build up in real estate markets. If real estate becomes a commodity bought and sold irrespective of its dependence of the wider economy – without concern for actual rental income or for people’s ability to pay their mortgages for example – then our theory suggests it can be full of unsupportable value, even as it is being bought and sold. Just as in the narrow market where the new derivative is being bought and sold.

it seems markets can be irrational, and part of that means they can convince themselves or let themselves become convinced that something is more valuable than it is. This seems to be especially the case if the market is hidden and cloistered away from the influence of the broader economy. Maybe irrational periods in larger markets are thrashed through more quickly because they respond to a larger number of collective opinions. But for whatever reason, if the links between the product and other products or transactions – say the links of wheat derivatives to farming or food production – are severed so that the product exists in economic isolation, then the market test of it’s value is less likely to be reliable.

As suggested, most current financial instrument regulation depends on exposing the instrument to the market as a way of forcing proposed value to be approved or denied. Two prime examples of how this is done are making trades take place in a centralized bourse or making financial institutions open their books to rating agencies. The other most common form of financial regulation is forcing banks, insurance companies and other similar institutions keep adequate reserves, which is designed to keep the institutions sound if the value of their financial instruments suddenly proves false.

Like the narrow markets mentioned above, rating agencies have at times shown a tendency to be too private in how they operate. This has lead to a pattern of insider dealing, which defeats some of the intention here.

But to get back to the issue of regulation, we could go farther then the current patterns. We could require new financial instruments to be tied more closely to the broader economy in a way that transcends public scrutiny. So for example, we might limit the size of derivatives that could be issued without also having some ownership (or working on behalf of the owner) of the underlying commodity. So for example we might say that no one could buy more than a few hundred thousand dollars in wheat hedges, without also owning some kind of interest in a farm.

Another approach that would have a similar effect without imposing as much inflexibility would be a stock transfer tax, requiring a tariff every time a stock or bond (or other more exotic financial instrument) is bought and sold. A stock transfer tax would make speculation more expensive, thereby limiting its spread.

The point of course is to allow for the creation of confirmable value, while minimizing the room for the creation of the false kind. A structure to do that might be difficult to design, but not impossible. Certainly no more difficult to design than a credit default swap.

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analysis/economics/value/value_proposed_and_confirmed.txt · Last modified: 2010/05/16 17:36 by ram